A Sector’s Pain Points Towards a Trade
Sneakers might be among the most overlooked investment opportunities. Over time, they have become fashionable and profitable. Although many investors failed to notice the trend, footwear became one of the best performing industries in the stock market.
Since the bull market began, the industry delivered a gain of more than 580% before pulling back in the past two years. This type of market behavior is consistent with a transition from an industry associated with growth to a potential value investment.
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Like all other industries, footwear, and sneakers in particular, provide multiple investment opportunities. In the high tech sector, we tend to watch the suppliers of the industry giants. In this low tech sector, we see the opposite pattern. The customers of the giants tend to fall first.
Footwear Retailers Show the Industry’s Woes
In recent weeks, two of the biggest retailers in the footwear industry have revealed significant problems. The chart below shows the stock price of two of the industry’s largest retailers.
Investors in Footlocker (NYSE: FL) have seen its share price fall more than 50% since the beginning of the year. And the bad news continues to mount. In August, the company said same store sales were down 6%, well below the guidance the company had previously issued.
Same store sales are an important metric for retailers. It shows how sales are growing at stores that have been open at least a year. This allows investors to see if demand for the retailers’ products is growing or the retailer is simply growing by adding more stores.
The drop in same store sales surprised Footlocker’s management. They had been expecting growth in the low single digits, or somewhere between 1% and 3%. Revenue fell 4.4% to $1.7 billion versus the previous guidance of $1.8 billion. Gross margin fell to 29.6% from 33% in the year earlier period. This indicated the company resorted to price reductions to move merchandise.
Management also warned investors that these negative trends in business are likely to continue. They told analysts to expect same store sales to drop between 3% and 4% over the rest of the year compared to 2016.
The other larger retailer in the industry is Finish Line (Nasdaq: FINL). Finish Line took the unusual step of preannouncing its second quarter results. Management will often preannounce earnings when they learn that the actual numbers will be significantly different than what analysts were expecting.
For Finish Line, the changes management noticed were negative. They now expect revenue for the quarter to be $469.4 million, significantly below earlier estimates of $477 million. Earnings per share (EPS) are now expected to be between $0.08 and $0.12, less than one third as much as the previous estimate of $0.38 per share.
As with Footlocker, the problem starts with lower same store sales. Finish Line’s management lowered its same store sales guidance from an increase in the low single digits to a decline of 3-5%.
For the full year, management cut its earnings guidance from a previous estimate of $1.12 to $1.23 per share to $0.50 to $0.60 per share. The stock fell 29% on the news.
Bad News for Nike?
At its most recent analyst meeting, Footlocker said NIKE, Inc. (NYSE: NKE) accounts for 67% of its total sales. Nike is also a large supplier to Finish Line.
Nike’s management is demonstrating an awareness of the problems of its retailers. The company is addressing that by increasing efforts to sell directly to consumers. Ecommerce sales of its shoes in the direct to consumer market have been growing 25% a year.
This will lead to slow growth for the company since this segment accounts for just about a quarter of its business right now. But, Nike is also looking to boost EPS with a large stock buyback. The company is in the middle of a $12 billion share buyback plan, expected to increase EPS by about $0.40 between 2017 next year.
Despite these efforts, the stock price has declined along with other stocks in the footwear industry.
A Strategy For Nike
The chart of Nike above shows that volatility has been rising recently. In the chart, volatility is shown with the average true range (ATR).
The ATR is simply an average of the true range (TR) and the TR is an indicator developed to correct a problem with the range calculation.
A stock’s price range is defined as the difference below the high and low price for a day. This calculation works fine most of the time but if a stock gaps up or down at the open, the range calculation will miss the volatility at the open. The TR corrects that problem.
The TR is the largest value of three values that need to be calculated each day. Those values are the current high minus the current low; the absolute value of the current high less the previous close; or the absolute value of the current low less the previous close. This includes the effect of gaps.
The ATR is a moving average (MA) of the TR. ATR measures volatility. It will increase in value when the stock’s price move are larger than they have been in the recent past. ATR will decline in value when a stock’s volatility declines and the values of the TRs become smaller.
In the chart above, a horizontal line was added to levels where volatility has been high in the past. When the ATR turns down from level, the price of the stock has moved into a trading range.
One option strategy that benefits from a stock in a trading range is an iron condor. This strategy has the added benefit of carrying limited risk.
To open an iron condor trade, the investor sells one call while buying another call with a higher exercise price and sells one put while buying another put with a lower exercise price. Typically, the exercise prices of the calls are above the market price of the stock and the exercise prices of the put options are below the current price of the underlying stock.
In an iron condor, the difference between the exercise prices of the two call options will be equal to the difference between the exercise prices of the two put options. The final requirement for this strategy is that all of the options must have the same expiration date.
The risks and potential rewards of the strategy are shown in the following diagram which is taken from web site.
Source: The Options Industry Council
The maximum gain on this trade is equal to the premiums received when the position is open. The maximum risk is equal to the difference in the two exercise prices less the amount of the premium received when the trade was opened.
Opening an Iron Condor in Nike
For NKE, the trade can be opened using the following four options contracts:
- Sell NKE Oct 6 $55.50 Call at $0.90
- Buy NKE Oct 6 $57 Call at $0.44
- Sell NKE Oct 6 $48.50 Put at $0.30
- Buy NKE Oct 6 $50 Put at $0.60
Of course, all of the options expire on the same day. The difference in the exercise prices of the calls or puts is equal to $1.50. Since each contract covers 100 shares of stock, this means the maximum risk on the trade is equal to $150 less the premium received when the trade was opened.
Selling the options will generate $1.20 in income ($0.90 from the call and $0.30 from the put). Buying the options will cost $1.04 ($0.44 for the call and $0.60 for the put). This means opening the trade will result in a credit of $0.16, or $16 for each contract since each contract covers 100 shares.
The maximum risk on the trade is $1.34, or $134 since each contract covers 100 shares. Most brokers will require a margin deposit equal to the amount of risk. That means this trade will require just $134 in capital.
The potential reward on the trade ($16) is 12% of the amount risked, a high potential return on investment. The trade will be open for about a month. If a trade like this is entered every month, a small trader could quickly increase the amount of capital in their trading account.